A Different Perspective - Views from the North

Ben Reitzes:

Welcome to Views from the North, a Canadian rates and macro podcast. This week I'm joined by TJ Sutter, Co-Head and Macro Portfolio Manager of Fixed Income at CCL Investment Management. This week's episode is titled A Different Perspective. I'm Ben Reitzes and you're listening to Views from the North. Each episode I'll be joined by members of BMO's FIC sales and trading team to bring you perspectives on the Canadian rates market and the macroeconomy. We strive to keep the show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback, so please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg, or via email at benjamin.reitzes@bmo.com. That's benjamin.R-E-I-T-Z-E-S@bmo.com. Your input is valued and greatly appreciated.

This week's episode is going to be a little bit different. For the first time, I am bringing on a client, someone from the other side of the business. It is my great pleasure to welcome TJ here. He is well respected in the industry and by me, so that's why he's the first one.

TJ Sutter:

Well, thanks for having me, Ben.

Ben Reitzes:

You're very welcome, sir. Before we get to market content, one of the things I think would be useful for the audience would be for you to quickly run through what your process is on the investment side of things. How do you make your decisions? What risks do you look at? How do you look at the market?

TJ Sutter:

Yeah, at CCL, my role is macro portfolio manager. We have a factor-based framework. Within our fixed income portfolios, I'm looking at what we define as macro factors or mostly within the rates space. So top-down, looking at broad duration positioning, yield curve positioning, top-down credit positioning, provincials versus investment grade versus high yield. We look at a global relative value factor, so Canadian yields versus US yields or other G-7 currencies, FX, things like that. Things you would overlay across our portfolios from a top-down perspective, adding the macro, adding alpha from a macro perspective. How we do that, we have a scenario-based framework. So what we start with is a qualitative scenario-based framework of the world. We look at the world and define how we think it might unfold, so we have a base case, a bull case, a bear case, et cetera. In today's example, you may have a soft landing as a base case, you may have a recession as the bear case, you may have no landing as the bull case.

We then price those scenarios across all of the factors, so we look at each scenario, and while defining it, how does inflation unfold under that scenario? How does growth unfold? What's the central bank reaction function? And then we use those inputs to forecast where our rate's going to be, where our credit spread's going to be, where is Canada versus US going to be, etc. Once we have all of our scenarios priced, we add probabilities to those scenarios. And from that, we get a probabilistic forecast at a certain point in time, usually about six months in the future, that we come up with.

Then we compare those forecasts versus the market, and from that we then hand off our forecast to a portfolio construction group that we then optimize the positions we have within our portfolio. For the broader goal of speaking about the market, it's important to understand how we're looking at things. I may say a recession is a base case, but it might only be a 40% probability. It may be our highest probability, but it might not actually be more than 50%. There are times where we've had recession as our base case, but we're actually short duration because the market is pricing it more than we've actually forecast where rates might go in that recession, or within our probabilistic framework. That's broadly how we look at things.

Ben Reitzes:

All right, I like that. What about tail risks? How do you take those into account? Is it even worthwhile, I guess, because there's tails on both sides, obviously. Do they just cancel each other out or do they ever enter into that framework and maybe take a little bit more weight than just the tiny tail that they are?

TJ Sutter:

Yeah, that's a good question. We would do it in two ways. One way we do actually have a tail risk scenario. Sometimes we have an entire scenario that's tail risk, something that might be unforeseen, a credit crisis, something like that. We'll add a non-zero but not significant probability to it. It might be between one and 5%, but it defines one of the edges of where the market could go should something break that is potentially unforeseen.

There are other tail risks that are, I think, a little bit more foreseen in the foreseeable future. One of those, I would say, is the US fiscal situation. Should that snowball into something bigger, something that the market cares about that weighs on term premium, that steepens the curve, the whole supply demand dynamic with US treasuries, something like that that is higher probability but it doesn't necessarily fall into one scenario bucket, we will have a bias in our forecast in recognition of the possibility that, let's say the outcome is a slightly steeper curve. We will add a slightly steeper curve across probabilities, acknowledging that we don't know when this might happen, but there is a probability in there, so there's a bias added.

Ben Reitzes:

Sounds like you have that bias right now.

TJ Sutter:

I do have that bias right now.

Ben Reitzes:

So do I.

TJ Sutter:

Yeah.

Ben Reitzes:

Good club to be in. I'm not sure how you could be any other way, actually, at the moment. Anything else you want to add on the process part before we move on to bigger market?

TJ Sutter:

No, I think that's it.

Ben Reitzes:

All right. Thank you for that. Much appreciated. What are you looking at right now? What? What's top of mind? Where are the greatest opportunities, and maybe where's the market most mispriced, if I can use that word, I don't know, relative to your scenario, your weighted scenario analysis?

TJ Sutter:

I think there are a few. It's an interesting time to be in macro, that's for sure. I would preface this by saying that the conviction level across the street, and that goes internally as well-

Ben Reitzes:

Is zero.

TJ Sutter:

... is quite low. And you've seen that, I've seen that, anyone you talk to, the conviction levels are quite low across the street. Anything I say is possibilities, but maybe not high probabilities. One thing that seems to surprise us is this assumption that the Fed is going to cut rates soon. And I like to look at the market as if you didn't have any context, any history, and you came from a different country and you looked at the US at least, and looked at where's inflation, where's three-month annualized inflation, where's core and super core, and where's growth above trend? Most people would come out of that without having any history of the 500 basis points of rate hikes that we just went through and say, "I assume the central bank's in a hiking bias, either looking to hike or communicating to hike."

And right now, the Fed is either pausing or cutting. Those seem to be their two routes. Powell has very clearly stated that they're not thinking about hiking, they don't want to hike, they want to cut, but the data has been a bit of a thorn in their side. So as a result, there seems to be an assumption that rates are going to fall, and absent something breaking, absent more evidence of a slowing economy and more stress in the financial system and in company earnings, you name it, I think rates are going to have a hard time rallying. So as it is a positive carry trade to be short duration, that is still our bias. Our bias is to be either neutral or short duration here. We recognize it's likely late in the cycle, but there's not a lot of evidence, at least in the US. Different story for Canada. So that's one bias we have. To take that one step further, I do question what the market looks at and assumes are as restrictive rates.

Ben Reitzes:

That was going to be my question. Are we in restrictive territory, and maybe are we just not at the point where we felt the full impact of those rates? There is a lag between when rates get hiked or cut, whatever, and have an impact. Are we just not really there yet because of the structure of the economy and where the debt is being held? So one of my many lines, and I have a great many of them, is that the greatest holder of debt in the US at the moment is the US government, and they don't care where rates are. They keep borrowing at 7% of GDP. That sounds like a great idea with the economy at full capacity. Notwithstanding that, they don't care where rates are, so when rates go up, they don't slow their spending. Meantime, households are in pretty good shape, 30-year mortgages, everybody knows the story there.

There's just not a lot of pressure from that perspective. And then so that leaves the corporate side of things. And I would argue it takes longer for the transmission to flow through to the corporate side. And so we have one bad payroll number, so I'm totally not going to harp on that, but maybe we're just getting to the point where you get a little bit of traction there, because you have seen pockets of softness. Earnings aren't quite as good as they have been. You see some areas that are not quite great. And even on the consumer side, I would argue that there's softness there also. Starbucks had lower traffic and lower volume sales, prices went up. And if you're feeling stretched as a consumer, the first thing to go is your $8 cup of coffee. Isn't that number one on the list to be cut? Do I need $8 coffee? Probably not. Don't need the calories, and don't need the expensive coffee. I guess, what are your thoughts on that?

TJ Sutter:

Yeah, it seems as though there's enough evidence to suggest that rates are restrictive in Canada.

Ben Reitzes:

No argument there.

TJ Sutter:

Yeah, we see that slowdown, you see that slowdown. We are an economy where the exposure to those rates turns over faster. The US, I don't think the evidence is there yet. I also think that there's something a little bit misconstrued when we talked about restrictive rates, and everyone talks about restrictive rates as the monetary policy rate. So the fed at five and a quarter to five and a half right now. But five and a quarter overnight rate with a 5% ten-year rate is a very different world than five and a quarter overnight rate with 380 ten-year rates, which is where we started the year at, especially in an economy that is a longer rate economy. And I do believe that there are long and variable legs to monetary policy as we all know and acknowledge, and we should be somewhere within a quarter or so of feeling the peak evidence, or feeling the peak pain from those hikes.

But I also think, and you've seen it in the markets, there's also a really quick pass through of some of this restrictiveness. When ten-year rates in the US rally to sub 4%, it heats the housing market back up, and that tells me that there's still pent-up demand out there, that the consumer's still strong, and then rates back up to 5%, and mortgage rates, US three-year mortgage rates go north of 8%. All of a sudden things slow right down.

And that seems to be enough to keep us on this roller coaster ride between the economy and financial conditions as they loosen a little bit and the economy actually starts to take off again and then, as a result, rates rise, we strengthen a little bit, and things slow down. Which means we're probably near the edge, but it feels very reflexive out there, the interaction between the economy and financial conditions. And so I'm not convinced that rates are restrictive in the US right now, but should that persist, then you would assume interest rates respond back up and I think there's enough evidence, I think last time, let's call ten-year rates got to 5%. That felt restrictive.

Ben Reitzes:

Okay. That would actually support the Fed's view that they're okay just holding here, and you'll get the curve bearish steepening to some extent. The longer they hold, the less willing they are to cut. You probably get some bearish steepening impulse, maybe not huge, but you don't need to be at whatever and low rates in tens, they can back up, maybe not all the way to 5%, but you can back up there.

TJ Sutter:

It feels like that needs to be the release valve as the longer-dated rates backing up in recognition of a stronger economy, and then that is in and of itself. And then if you've held rates this type for this long, and don't get me wrong, there are enough industries exposed to front-end rates, to overnight rate or floating rates, they are feeling stress. The probability that something breaks within that time horizon does continue to increase as we go through time, and so we get closer to a potential recession or a potential loss of jobs, whatever it might be.

Ben Reitzes:

Okay. It sounds like you want to see some softness in the labor market, and then that weighing on consumers and so on and so forth, kind of like Canada. The Canada picture is much less ambiguous. We're weak. I think everyone knows it. If population growth were in here, we would just look horrendous, but we could look like most of the rest of the world. I think it's almost like everybody is rate sensitive except for the US, and maybe there's more to it than that. Maybe there's some US economic exceptionalism attached to that as well, which is, you can never put your finger on it until after the fact, but their higher investment rate and so on and so forth is clearly very positive, and for Canada, it's clearly very negative. Our weak investment rate, our obsession with housing, our just poor productivity record in general is quite unfortunate. Given that you look at a lot of markets, how does the weakness in Canadian productivity, and historically Canadian assets on a relative basis, it's less of a fixed income story, but still, how does that feed into your decision making?

TJ Sutter:

Yeah, productivity question is an interesting one. It's something that everyone acknowledges.

Ben Reitzes:

It's been 40 years of questions and no one has an answer.

TJ Sutter:

But almost acknowledges as a given now, as opposed to something that we hope or expect to change. As you said, I think the real story is US exceptionalism and not necessarily Canadian inferiorism, if you want to call it that.

Ben Reitzes:

It's a new term he's coined.

TJ Sutter:

And as it relates to the US, the combination of having thirty-year mortgage rates, first and foremost, coupled with this incredible fiscal impulse they have, and the tech sector leading the entire world in growth and jobs, this combination of factors have created this moat around them, which is quite awesome, to be quite frank. In Canada, we like to criticize the Americans of a lot of things, most namely politics, but quite frankly, their economy is in a pretty good spot. As it relates to Canada, again, I've used this term, but there is a release valve in that, and how long-lasting this decoupling can last, I think, between the US and Canada.

I feel like as long as, at least as far as the narrative goes, we're probably near peak bearishness on Canada versus bullishness on the US. One has to assume it's nearly priced in, and at some point the release valve is the Canadian dollar, which does support a domestic manufacturing industry. It supports commodities, etc. And you would expect that to flow back through to Canada at some point. I don't think we've quite seen it yet, and you haven't had maybe the degree of weakening in the Canadian dollar that you might've otherwise expected, but should the Bank of Canada get out ahead of the Fed, that likely then continues, and you start to see that flow back, and I assume you see the economies recouple, maybe quicker and maybe a little bit more so than most of the market is expecting right now, as these bearish bullish opposing narratives really take hold.

Ben Reitzes:

It sounds like you think the Canadian dollar is going to weaken.

TJ Sutter:

Near term.

Ben Reitzes:

Near term. I have trouble arguing with that. Even long term, I have trouble arguing with that, even though selfishly I definitely want it to appreciate. I guess, why would it ever come back? If we are in a weaker growth economy on a relative basis, we have a lower R star than the US as well, shouldn't we be five to 10 cents cheaper and just stay there? And there are repercussions for that. My problem, you mentioned manufacturing and how a weaker dollar helps that, and sure it does, and we've gotten some EV plants and new auto plants and battery plants and that stuff, which we have paid an awful lot of money for, but I'm not convinced that a weaker currency is really going to bring anything back to Canada anymore. We had an exodus of manufacturing and foreign companies, and on the energy side, on the resource side, an exodus there as well, when oil became a bad word and all the internationals wanted to leave the oil sands and they sold their positions.

And so even if we have a weaker currency, which historically it's the release valve, and eventually maybe it makes a difference, but is five to 10 cents enough? Is that going to prompt anyone to want to say like, "Oh, Canada is cheap, I want to build my next plant there?" Or is it just more than that? And the regulatory environment here is pretty challenging. The tax environment here is pretty challenging. And maybe the currency needs to be materially weaker. I don't really even want to put a number on it because it scares me to think about it personally. We'll just be trapped in Canada forever, to never leave the country again. But that worries me, and I don't know. I'm not convinced that's not the case.

TJ Sutter:

Those are fair questions. Questions-

Ben Reitzes:

I don't think there's an answer.

TJ Sutter:

Questions I certainly don't have the answer to, and especially in talking about things like productivity, I'm not an expert in that. We view the facts as given, and that is a given fact, but all your points are well taken.

Ben Reitzes:

This is all what goes through my head. I'm like, oh no, I don't have an answer for this.

TJ Sutter:

Yeah, if we want to pull it back to the things we're looking at. And so, one thing you did say there that stuck out to me was do we have a lower R star in Canada? And that seems to be one of the natural outcomes that you're bringing out of this is that we do. We have a lower neutral rate in Canada, we have lower productivity, and so let's take that as a given. Then let's also assume that we are restrictive in Canada, and the ingredients seemed to be in place for an upcoming Bank of Canada cut.

Ben Reitzes:

Do you think they cut in June, was going to be my next question?

TJ Sutter:

I'm on the fence. It's June or July.

Ben Reitzes:

Yeah, okay.

TJ Sutter:

Let's say there's a cut between those two months. Let's assume that's a given, and let's also assume that the US economy remains somewhat resilient and they can't cut. Let's say the earliest is September right now. So you get Canada cutting, you have lower quote-unquote neutral rate in Canada, they have all the ingredients to cut. The Canadian curve is still much more heavily inverted than the US curve. So taking that back to a view and a position, we do believe that Canadian curve should steepen coming into this, especially relative to the US curve here. There should be reasonable opportunity in a relative steepening in Canada versus US and other countries, for that matter.

Ben Reitzes:

Does June 1 factor into that for you, or I guess this year it's June 3rd ,and the index extension that drives buying further at the curve? Do you tactically use that to put positions on, knowing full well that on June 3rd, there will be lots of passive buying, especially in the long end?

TJ Sutter:

Yeah, it's always a consideration. Take it all the way back to our process, but I set our forecast, and I will forecast our curve levels, and that will feed into our portfolio construction team, which will come up with the optimal portfolio for us to invest in. And then that goes to our execution team, which every team, every day, is slowly steering our portfolio to our optimal portfolio. But there is opportunity for us and tactical reasons for us to maybe hold off doing a trade for a day, a week, or two weeks, whatever it may be, given the supply-demand, technical, structural aspects of the market.

In knowing that an index can naturally take you short or naturally put you into a curve position, you actually might save trading costs by just letting the index do a trade for you. So it's always a consideration. Every day we're trading towards our optimal portfolio, and in acknowledgement that there's a big June 1 coupon coming up and that curves typically flatten into it, whether it be both outright and versus the US, that if the way we would think about that as if it's a position we're looking to get into, we might be patient and wait for some of that flattening to execute, or wait for the index to move that position.

Ben Reitzes:

We talked about US fiscal worries and supply there. How about on the Canada side? There are a lot more Canadas, maybe not as many as we thought there'd be, or at least not as many as I thought there'd be coming into this year. There's lots more provis, but they also, they've done a great job at funding overseas really aggressively, but still issuance is poised to be relatively high. We haven't seen the same type of pressure on cash product in Canada that we have in the US. Is there some concern there? Is there worry? Do you have worries on the fiscal side at all or, maybe just the cheapening of cash product in general, kind of like we've seen in the US, rather than think about it as fiscal risk? Maybe there's just some room for those bonds to cheapen or maybe provi spreads to widen.

TJ Sutter:

Yeah, well, I think you've seen the provi spread widening, and provincial spreads look really cheap on most metrics versus investment grade and high yield and other credit metrics. We actually are quite constructive on provincial spreads because we think they're within a stone's throw of recessionary pricing as it is. As it relates to pressure on cash yields, from the supply perspective, it is interesting because you have to look at it relative to the US, it's a drop in the bucket. But absolute yes, our net supply is growing, and one would think, and this is very consensus, so I hate saying things that are too consensus, but it should build more term premium over time into the Canadian curve. Now that also acknowledges that as we all know, for the last 15 years there's been excess demand relative to the supply of long-dated issuance in Canada and long duration products.

So at what point this increase in net supply, does that at some point move the long duration product available in Canada from a, call it net deficit to net surplus type situation, where you then start building in some term premium and tens thirties curve in Canada starts trading soft and not strong 80% of the time. That's an open question. It's something we acknowledge as a possibility, but to time that is nearly impossible. So it's something we watch and monitor closely. And I don't have a strong view on the timing, but I certainly recognize there's a strong possibility of that, given the supply dynamics that are ever-changing.

Ben Reitzes:

Last two questions. How many cuts from the bank this year? How many cuts from the Fed?

TJ Sutter:

I'm going to go two.

Ben Reitzes:

You can do your weighted scenario or you can just pick your most likely.

TJ Sutter:

Let's keep it simple. Two from the bank of Canada, one from the Fed.

Ben Reitzes:

Two.

TJ Sutter:

And I'm hesitant to say the one. If anything, I personally think the bank probably goes twice and then pauses and wants to see the flow through to housing. I'm assuming there's not some drastic recession, big job loss that's going on here, but they're normalizing within the backdrop of weak economy and inflation that is close to trend or at trend. I think they're going to be moderate within this process, though. So two, then pause. And they don't want to see animal spirits come back to housing too quickly. On the US side, I'm between zero and one, but you probably sneak one in December. Yeah, it seems like the bar's pretty low to get that cut because-

Ben Reitzes:

They want to cut.

TJ Sutter:

... they want to cut. And so, you get one or two months of just sporadic week data, that's going to give them the green light. It seems like it.

Ben Reitzes:

Okay. I don't take much issue with that. The bank is going to be cautious, for sure. They should be cutting, but they're not going to be doing it aggressively. And last question would be, I guess you've kind of already told us, but maybe you'll outline it again, favorite trades, favorite big thoughts for the market, where you want to be, what you want to be, long, short, et cetera?

TJ Sutter:

Yeah, I will say this is a tricky market to have overarching favorite trades. Where we are right now, there are times we'll have big structural positions on because we have strong views as to where we're heading in 6, 9, 12 months. This is not that time. And so, quite frankly, we're happy to sell duration on rallies and then lighten up when it gets back into what seems to be back into more neutral or restrictive territory. We do have a bias for steeper curves. I know that isn't out of consensus, but the timing in which and the structure of which we do that is part of our expertise.

I don't know if this is too detailed for the podcast, but we are short the five-year fly versus twos and tens. We actually quite like that. Structurally, that actually trades with positive carry, being short fives versus twos and tens on the curve. It also correlates with steeper curve. As you know, steepening trades right now are quite punitive from a carry perspective. There's a way to structure some exposure to a steeper curve in recognition of how expensive fives are in the curve in Canada. And once we move into a rate cutting cycle, the torque of this steepening should happen between twos and fives. We like that from a structural positioning standpoint.

Ben Reitzes:

You don't worry about bank treasury receiving in that area given lack of mortgage flow? Because I don't know, I don't see the mortgage market, the housing market, really picking up. And you don't, there's no way you do with just 50 base points, either. And so the mortgage market's going to stay shorter. The people are only going to take out two and three year mortgages. No one's taking out a five year unless that curve goes wicked inverted, which I just don't see happening. And that means ongoing receiving, which keeps five rich, and it's just hard to fade that.

TJ Sutter:

It's a risk, but which seems reasonably priced given current valuations. And I don't know, maybe 50, there's an outside chance that 50 beeps gets the animal spirits of Canadian. Don't underestimate the Canadian homeowner, or the desire to buy houses on the wink at a cutting cycle. That's not a forecast, but it's a possibility. And I think those bank treasury risks are well priced.

Ben Reitzes:

Okay, Already very rich, so why not?

TJ Sutter:

And you're not paying to be in the position.

Ben Reitzes:

Which helps. Positive carry trades are always good in a challenging environment. All right, TJ, thank you.

TJ Sutter:

All right.

Ben Reitzes:

Hopefully this will be well-received and we'll have you back on again one day when I come to Vancouver.

TJ Sutter:

Yeah, I enjoyed it. Thanks, Ben.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian rates and macro podcast. I hope you'll join me again for another episode.

Speaker 3:

The views expressed here are those of the participants, and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.